Is a Roth 401k Better than a Traditional 401k?


IMG_0120We’ve all heard the conventional wisdom.  If you have an old, stodgy traditional IRA you should convert to a snazzy new Roth IRA.  There is now even a new Roth 401k.  Sure, you’ll need to pay all of the taxes since the money was initially invested tax-deferred and the conversion requires that the taxes be paid immediately.  For an account of $100,000 this could mean a tax bill of $20,000 or more.  But it will be worth it in the long-term, right?

Well, maybe.  It is true in general that if you are investing for a long time before retirement, the mathematics show that a Roth IRA , where after-tax funds grow tax-free, will do better than investing in a traditional IRA where funds are not taxed until withdrawn from the account at retirement.  This is true even if you invest the tax savings (the money that would have gone to taxes) in a taxable investment account rather than spend it.  This is because the large amount of growth in the IRA will not be taxed, so when you are withdrawing your millions later, because you paid the taxes on the thousands you put into it now, you will end up with more money.

But those making the above calculations leave out some important factors.  First of all, they assume that you are investing for a long time period, such that the money you put into the Roth IRA will have years to grow, compounding ad nosiuem such that the amount gained from interest and capital gains will far exceed the funds deposited.  If you are putting funds into an IRA for a shorter period of time — 10 years before retirement, for example — it may be better to put the funds into a traditional IRA.  This is because the money has little time to grow (15 years or so), and if your withdrawals are small enough, you may be in a higher tax bracket when you are making the money than when you are withdrawing it.  It may therefore make sense to make tax-free Roth IRA contributions early in one’s career when in a lower tax bracket and with many years before retirement, and then make increased tax-deferred contributions into a 401K or Traditional IRA when near retirement.

The second big factor that is left out of the calculation is politics and all of the things that can happen in thirty or forty years.  Because the rules can be changed at any time at the whim of the legislature, your calculations may be meaningless.  This is particularly true with the current demographics.  We have a large percentage of the population who have saved nothing for retirement, and a few people who have saved a great deal through IRAs and Roth IRAs.  This has led to a situation where some individuals have millions of dollars, and others have almost nothing (or negative balances, in some case).

Given that the nothing-savers far outnumber the big savers, it could be very popular to establish some sort of wealth tax (as the inheritance tax is already) or change the rules on the Roth IRA withdrawals, charging a “distribution fee” or some other form of tax.  After all, “how is it fair that some people have lots of money, and others have none”, the thinking will go.  Even if the rules are not changed, the taxes on dividends and interest as funds from the Roth IRA are pulled out and put into fixed-income securities could rise to high levels as governments try to balance their books.

Another possibility is that the income tax could be abolished or radically changed.  For example, the Fair Tax idea has been around for years.  In this scheme, income taxes would be eliminated entirely and replaced with a national sales tax.  To make things “fair” each individual would receive a prefund (beginning of the year refund) such that those who make little would pay essentially nothing in taxes, while the larger spenders would pay more.  If such a tax scheme were enacted, the Roth IRA tax-free growth would evaporate.  There has also been talk about eliminating the income tax and replacing it with a Value Added Tax (VAT), which is similar to a sales tax.  Here again, the Roth tax-free growth would be eliminated.

The bottom line is to not get too enamored with mathematical calculations when it comes to finances.  One must always remember that the rules can change and the risk of rules changes affecting results, particularly when large time periods are involved, must be taken into consideration.  As the old saying goes, a bird in the hand is worth two in the bush, and perhaps sometimes it is better to save the taxes now than save the taxes later.  So go ahead and save up for retirement, putting away at least 10-15%, but think about spreading it out between tax-deferred and tax-free growth, just to play both sides of the table.  Also, think long and hard before converting a traditional IRA to a Roth IRA, particularly if it is a large account.  In particular, if you do not have the funds available to pay the taxes without touching the balances of the IRA, it may not be worth it.

To ask a question, email  vtsioriginal@yahoo.com or leave the question in a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing

5 thoughts on “Is a Roth 401k Better than a Traditional 401k?

  1. Great post, good rational perspective on a sometimes confusing topic. My wife and I are high income earners in our mid careers and I’m looking for all the tax savings I can get. My assumption is that in retirement, our expenses (and therefore realized income and taxes) will be much lower as we will not need to be paying for a mortgage or saving as much as we do now.

    • Don’t forget about medical, which I’ve heard estimated at about $250,000 for a couple over their retired lifetime. Also, remember that there are minimum required distributions from tax-deferred accounts like IRAs and 401ks after you hit 70 and 6 months, that can force you to take income. In general, however, you probably will be lower income and therefore lower taxes, which is fair since you’re probably paying a lot of taxes right now. (Thanks for the road repairs, by the way). Thanks for the comment.

      BTW – have you looked at where you are financially using the criteria Stanley came up with in Millionaire Next Door? Multiply your age by your income, then divide by 10. If your net worth is above that, you’re considered by him to be one of the rare people who will likely become a multi-millionaire.

  2. Good one. Especially the part regarding putting emphasis on too much calculations while planning for retirement. Change of rules can affect the calculation and in turn results in positive as well as negative way. Better to plan it as per current rules with a situational flexibility of the future kept in mind.

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